In my last post I said that Rachel Reeves’s statement last week, and more generally the way fiscal policy has been done since 2010, had nothing to do with the OBR. Many have subsequently questioned this, noting that the OBR was set up in 2010 by George Osborne. When one of the UK’s best journalists suggests that the OBR’s “creation has had unintended consequences and reinforced a short termist, tail chasing psychology to UK economic policy making” you know that these misconceptions about the OBR are widely shared.
Why are they misconceptions? Because the OBR was created to do one key job, and that was the macroeconomic and fiscal forecasting that had previously been done by H.M.Treasury. The Treasury had, by act of parliament, produced a forecast twice a year, so the OBR did as well. The Treasury before 2010 also did a 50 year projection once a year, so the OBR does too. Essentially the Treasury farmed out its macroeconomic forecasting to this new, independent body.
One reason George Osborne liked to give for doing this is his belief that under the previous Labour government Chancellors had leant on Treasury forecasters to produce more favourable forecasts. That may well have happened occasionally (under both Labour and Conservative Chancellors), but it certainly wasn’t routine, for the very good reason that if Chancellors regularly did this Treasury forecasts would lose all credibility. As I showed here, under Gordon Brown Treasury forecasts were at first far too pessimistic about the public finances, and then too optimistic, but it was in 2009 that the Treasury produced forecasts showing massive deficits without policy changes.
So if the OBR had never been created, and the Treasury was still producing its macro forecast, it is almost certain that Osborne's austerity would still have happened, and Reeves would have done exactly what she did last week. Why can I be pretty certain of the latter? Because it was widely known that both growth and tax receipts had been disappointingly poor since the October forecast, and long term interest rates were also higher, so Treasury forecasts were bound to show the deteriorating outlook for tax receipts that I discussed here. If they hadn’t then journalists would have been rightly complaining that Treasury forecasts lacked credibility and that these forecasts should be farmed out to an independent body! [1]
So why is there this misconception about the OBR? [2] The answer is straightforward. The OBR was created at the same time and by the same person who solidified a change in the way UK fiscal policy was done. Before 2010 Chancellors would say that aggregate fiscal policy was about achieving a good macroeconomic performance as well as achieving fiscal rules. From 2010 aggregate fiscal policy became just about hitting fiscal rules. Also important was that Gordon Brown, because of the Treasury’s pessimism noted above, had reduced public debt substantially at the end of the 1990s, so meeting his fiscal rules did not become an issue until the second half of the 2000s.
Osborne thought that by focusing on the deficit he was just following the academic consensus, which said that monetary policy should control short term output and inflation and aggregate fiscal policy should target debt and deficits [3]. His great mistake was not to notice that, both before and certainly following the Global Financial Crisis, macroeconomists were shouting ‘but not when interest rates hit their lower bound’, which they had in 2009. Brown’s government had understood this, which is why fiscal policy was very expansionary in 2009, but it suited Osborne politically to pretend he hadn’t heard or disagreed.
While interest rates remained at their lower bound, fiscal policy should have been directed at achieving a stronger recovery, and debt or deficit targets should have been put to one side. That this didn’t happen is almost certainly partly responsible to some extent for the UK’s poor productivity performance that became evident in the 2010s, and which led to poor growth in real incomes. Since the 2010s productivity growth has declined even further (see here, for example), undoubtedly because of Brexit but also perhaps because of a very badly handled pandemic and continuing austerity.
However, for the last few years interest rates have been well away from their lower bound, so it makes macroeconomic sense to focus aggregate fiscal policy on achieving fiscal rules. Ensuring we have the maximum level of output consistent with stable inflation can be safely left in the hands of monetary policy. Does this mean that any dissatisfaction with what happened last week should be directed at the fiscal rules Reeves has adopted?
Again I think this is mostly wrong, but first let’s be clear what fiscal rules we are talking about. Reeves has two, a ‘falling debt to GDP’ rule and the golden rule, which says spending excluding net investment has to be matched by taxes. The first is economic nonsense, and very damaging nonsense at that, for reasons I outline here. But the rule which is currently binding is the golden rule, so in the remainder of this post I will focus on this.
In my view the golden rule makes a lot of sense. It allows the government to invest as much as it likes, but it says that future taxes should cover planned future current spending. Broadly this rule ensures that government debt stays roughly stable as a share of GDP in the longer term. If we allow future current spending to always be significantly in excess of expected future taxes, the debt to GDP ratio will rise exponentially. That is not sustainable in the long run. [4]
Reeves made two mistakes last week. The first was to think the OBR’s non-budget forecast had to show the fiscal rules being met. As I argued in my last post, a more grown-up fiscal policy would have simply noted the OBR’s forecast, and pledged to take action to meet the fiscal rules in her next Budget. This approach would have been consistent with Reeves’s sensible pledge to hold just one Budget a year, while what she did last week was not. The bond markets would not have collapsed as a result. Her second mistake was to cut spending rather than raise taxes, for reasons examined in detail here, and what is more cutting spending in a particularly cruel way.
Changing fiscal policy just once a year does something to tackle the charge of short-termism highlighted at the beginning of this post. But what about the ‘doom loop’ idea? This is that if growth falters, the deficit increases, leading the Chancellor to cut spending or raise taxes to meet her fiscal rule. But raising taxes or cutting spending reduces output, increasing the deficit, and we get into a downward spiral. If this is what following the golden rule implied, then you could indeed claim that it was helping to depress growth in the longer term.
If interest rates were at or close to their lower bound this would be a real concern, which is why fiscal rules should not apply in these circumstances. But when interest rates are well above their lower bound, as they are now, the doom loop will not operate because tightening fiscal policy will allow monetary policy to stimulate the economy. Crucially, however, monetary policy has to have time to do this, which means that the golden rule should apply to plans and forecasts five years ahead, rather than two or three years ahead. A little noticed mistake that Reeves made in her October budget was to change the golden rule to apply over a three year rather than a five year horizon, which precisely risks creating a doom loop (see the ‘fiscal rules’ section of my post-Budget post here). Needless to say I have seen no analysis in the media about this change, and why it might be harmful.
Why did Reeves make these two mistakes last week, and her mistake in altering the golden rule in October? Of course ministers remain responsible for what they do, but I suspect advice from the Treasury was far from helpful, and that Reeves and her fellow ministers are ill-equipped to depart from Treasury advice. In turn the Treasury may be making poor decisions in part because it has suffered from more than a decade of politicians pursuing poor macroeconomic policy.
I suspect the Treasury would have advised her, incorrectly, that it would be very risky to just note last week’s OBR forecast, with a lot of hand waving and frequent mentions of Truss. It may also have been the Treasury that preferred to listen to the great and the good (including in this case Lords) on fiscal rules without asking those who know rather more about them. This is speculation of course, and I’m happy to hear (in confidence) if I’ve got this wrong. What is clear to me, however, is that last week had nothing to do with the OBR and little to do with the 5 year golden rule, both of which remain valuable bits of the UK’s fiscal framework.
[1] Daniel Susskind argues in the FT that the OBR encourages the Chancellor to adopt policies that the OBR thinks will encourage growth, rather than policies that the Chancellor thinks will encourage growth. I doubt this very much. What the OBR does is look at the evidence in the literature, as it has done with the economic effects of Brexit for example. This is surely a better way to forecast than personal hunches or political wishes. I also doubt very much that the OBR's assessment of this evidence would have much influence on a Chancellor's political agenda.
[2] Criticism of particular judgements the OBR makes is something completely different. Indeed one of the advantages of the OBR is that it is pretty transparent about the judgements it makes, which allows others to criticise them.
[3] Of course individual tax measures can be designed to improve productivity. Osborne thought that cutting corporation tax would boost investment. It didn’t.
[4] In the long run we are all dead, so who cares? The simple answer is our children’s children, who will have to deal with a fiscal problem that is much more difficult to solve than it is today.
